Treatment of foreign exchange gains and losses in macro-economic statistics

This article was published in Australian Economic Indicators (Cat. No. 1350.0), April 2002

INTRODUCTION

The Australian Bureau of Statistics (ABS) compiles a wide range of economic statistics to assist analysis of the performance of the various components of the Australian economy over time. Core sets of these statistics are organised into sets of economic accounts, such as the national and international accounts. These accounts are compiled according to international standards to ensure coherence and consistency. International standards prescribe methods of valuation of stocks and flows and methods of tracking and recording changes in these valuations over time.

Australia has an open economy, with a floating exchange rate regime and deregulated financial markets. As a result, Australian enterprises with dealings in foreign currencies are exposed to exchange rate fluctuations. A significant cause of changes in the valuation of financial assets and liabilities over time, and hence the positions between domestic sectors, and between Australia and the rest of the world, is changes in the exchange rate between the currency in which financial instruments are denominated, for example $US, and the Australian dollars in which Australia’s accounts are compiled.

The volatility in exchange rates and the resulting foreign currency exposures have led to the use of increasingly complex techniques to manage these exposures. The exposures are managed through derivatives which are financial asset and liabilities in their own right, and need to be valued for inclusion in the economic accounts. This article presents an overview of the concepts and methods of reporting foreign exchange gains and losses and the derivatives used to manage foreign exchange exposure in macro-economic statistics.

ABS MACRO-ECONOMIC STATISTICS

Economic account statistics, such as the national and international accounts and government finance statistics, organise and aggregate economic statistics into a systematic and comprehensive picture of economic activity. These accounts need to be accurate and relevant if they are to provide useful information for the analysis of current policy issues. To achieve these aims, as well as to allow international comparability, the economic account statistics are compiled and presented in accordance with harmonised international statistical standards. These standards are set out in the 1993 Edition of the System of National Accounts(SNA93), the Fifth Edition of the International Monetary Fund’s (IMF) Balance of Payments Manual (BPM5) and the IMF’s Government Finance Statistics Manual (2001 edition).

One aspect of the usefulness of the economic accounts as an analytical tool relies on their ability to provide a
systematic summary of numerous and varied economic activities using standard concepts and valuation methods. In
particular, international statistical standards require transactions in, and stock levels of, assets and liabilities to be
presented at their current market value. Market value is for all practical purposes equivalent to the fair value concept
used in business accounting standards, and is defined as the amount of money a willing buyer pays to acquire
something from a willing seller, when such an exchange is between independent parties and one into which only
commercial considerations enter. This results in the economic accounts measuring the current exchange value of all
assets and liabilities in current money terms, that is the value at which they are transacted, or could be exchanged,
for cash.

There is widespread user interest in the economic performance and wealth of the various sectors in the economy.
For the economy as a whole, the position of assets less liabilities in the balance sheet provides an indication of
national wealth. For an institutional sector, the net position of assets and liabilities provides an indicator of economic
status when measured using current market values. Corporations are exposed to numerous risks such as credit risk,
liquidity risk, exchange rate risk, interest rate fluctuations, movements in market prices and counterparty risk. Market value measures the current exchange value of all assets and liabilities in current money terms, and measures the
impact of these risks on economic performance more accurately than the use of alternative methods of valuation
such as book value, which is likely to misstate the values of instruments and be applied asymmetrically by
transactors.

To produce a consistent set of financial accounts by sector, the assets owned by one sector must be valued on the
same basis as the corresponding liability of another sector. If these asset/liability pairs are valued in different ways,
say one at face value and one at market value, inter-sectoral positions are misstated in economy-wide accounts.
Market valuation is the most reliable way of valuing these pairs in a consistent manner as it is based on observed
prices, that is the price at which an instrument actually trades. Similarly, it is important that each side of a
transaction be valued on the same basis. Business accounting treatment may be different, in that there is no
requirement for the asset/liability pairs to be recognised and valued the same by both parties.

It is not always possible to observe a market price for a financial instrument, and in these cases the best available
proxy must be used. Assets and liabilities will often be recorded in enterprise accounts at the price levels ruling at
the time of acquisition, since accounting treatments are often primarily historic cost focussed. The value at which
the asset or liability is recorded in financial statements is known as the book value. For non-current assets, the book
value is generally the historical cost which represents the amount paid for the asset. For financial instruments, face
value, which is equivalent to the principal repayable to the asset holder at maturity, is often used. These value
concepts can often differ significantly from the current market value of an asset.

The difficulty associated with obtaining current market price for some assets and liabilities is recognised, particularly
those which are only rarely transacted, and practical valuation guidelines are provided to assist respondents in ABS
surveys in approximating market valuation as closely as possible. For some non-equity instruments (essentially
loans, deposits and accounts receivable or payable) face value is regarded as a reasonable approximation of market
value as these instruments can be realised on demand or at short notice for their face value, or cannot be transferred
readily from one entity to another. For equity investment in unlisted enterprises, where a market value of the shares
is not available, the survey respondent is asked to estimate the market value by one of the following methods (in
descending order of preference): a recent transaction price; director’s valuation; or net asset value. The market
value for debt securities is sought on one of the following bases (in descending order of preference): yield to maturity; discounted present value; face value less written down value of discount; issue price plus amortisation of
discount; or another mark-to-market basis.

An element in market price valuation is the conversion of financial assets, liabilities and transactions expressed in
foreign currency to Australian dollars. International statistical standards state that, in principle, they should be
converted at exchange rates ruling at the reference date.

FOREIGN EXCHANGE GAINS AND LOSSES

International statistical standards stipulate that each asset, liability, income and expenditure arising from entering
into a foreign-currency-denominated transaction should initially be measured and brought to account in Australian
dollars using the exchange rate in effect at the date of the transaction. At reference dates subsequent to the initial
transaction, foreign-currency- denominated assets and liabilities are converted at current exchange rates to
determine the domestic currency values. Exchange rate gains and losses are not treated as transactions in the
economic accounts, but appear as valuation changes in the reconciliation of the value of assets and liabilities at the
beginning of the accounting period with the values of assets and liabilities at the end of the period.

This treatment can be illustrated in the following example involving the raising of a foreign currency liability. Consider
an Australian enterprise requiring a 12 month loan in Australian dollars to fund its local operations. The Australian
enterprise finds it can reduce costs by borrowing in a foreign currency, and enters into a loan with overseas lenders
for $US100. If this loan was raised on the 1 November 2000, and the $A/$US exchange rate on this date was 0.5240,
then this transaction would be reported in the financial account of the Balance of Payments at $A190.84. At the end
of the December quarter 2000 this liability had not been repaid. The $A equivalent of $A179.05 as at the 31
December 2000 is calculated using the exchange rate of 0.5585 prevailing at this reference date. The reduction in the
liability of $A11.79 is caused by a foreign exchange gain during the quarter, and is recorded as a valuation change in
the International Investment Position statistics. This foreign exchange gain is not a transaction, so it has no impact
on Balance of Payments statistics.

The reason that foreign exchange gains and losses are not recorded as transactions in economic statistics is that
transactions generally involve an exchange of economic benefits between two parties. A foreign exchange gain or
loss, on the other hand, does not give rise to such an exchange. However, when foreign exchange gains or losses are
realised in a transaction involving the disposal of an asset or a repayment of a liability denominated in a foreign
currency, then the realised gains or losses will be reflected in the Australian dollar value recorded for the relevant
transaction.

An important consequence of this is that foreign exchange gains and losses do not affect income as measured in
economic accounts, which can only arise from transactions. But foreign exchange gains and losses do affect wealth
as recorded in balance sheets through the market valuation process described above.

FOREIGN EXCHANGE GAINS AND LOSSES ON DERIVATIVE CONTRACTS

Continuing volatility in exchange rates has seen increased use of financial derivatives by Australian enterprises for
hedging purposes as part of foreign exchange risk management practices. Financial derivatives are financial
instruments that derive their value by reference to the price of a specific underlying financial instrument, indicator or
commodity. In compiling economic statistics, financial derivatives are treated as financial assets and liabilities since
they can be considered to be a store of value. Transactions involving derivatives are recorded as transactions in this
type of financial asset, and not transactions in the underlying assets to which they may be linked.

A common reason for Australian enterprises entering into derivative contracts is to hedge foreign currency exposure.
Hedging describes a financial technique used to offset the risk of loss from price (in this case exchange rate)
fluctuations in the market. For example, the borrower referred to above has an exposure resulting from his financing
of his normal business activities and may wish to limit his exposure to exchange rate fluctuations by entering into a
particular form of derivative contract with a counterparty prepared to take on the exposure. The most common types
of derivative contracts used for hedging foreign exchange exposures in Australia are forward contracts, foreign
exchange swaps, cross currency interest rate swaps, and currency options. Forward contracts are contracts to buy
or sell $A in exchange for foreign currency at a pre-agreed exchange rate at a specified future date. Foreign
exchange swaps combine a spot exchange of two currencies with a forward transaction that reverses the initial
exchange (though generally at a different exchange rate). Cross-currency interest rate swaps involve the exchange
of the values of streams of interest payments in different currencies for an agreed period of time and the exchange of
the values of principal amounts in different currencies at a pre-agreed exchange rate at maturity. Currency options
grant the holder the right, but not the obligation, to exchange $A for a foreign currency at a specified exchange rate at
a future date.

It is important to note that not all derivative contracts recorded in the economic accounts are for the purpose of
hedging, that is for the purpose of offsetting risk of loss from exchange rate fluctuations. For example, a
cross-currency interest rate swap can be used to alter the cash flows, and therefore risk, of existing funding
arrangements. Financial derivatives may also be used for other purposes such as speculation and arbitrage between
markets. Also, derivative contracts denominated in foreign currency can be between resident and non-resident
counterparties or between two resident counterparties.

Market Value of a Derivative Contract

As with all financial assets, derivative contracts are measured in ABS economic statistics at their current market
value. This market value is equivalent to the mark-to-market value of a derivative contract which shows the expected
close out value of the contract. Whether the market value of each individual contract is positive or negative
determines the classification to either net asset (in the money) position or net liability (out of the money) position.A derivative contract derives its value from the principle that the underlying asset is valued in the statistical system
at its current, not contract, price. For traded contracts prevailing market prices are used. For non-traded option-type
contracts, market value is approximated using a pricing formula, such as the Black-Scholes formula. Market values
for non-traded forward-type contracts are estimated using the present values of future net cash flows. These future
net cash flows are determined from the difference between the contract value and the expected prevailing market
value of the underlying asset on the future settlement dates. Transactions in financial derivatives are recorded when
financial derivative contracts are created, traded or settled.

In the example presented earlier in this article, the Australian borrower is faced with the risk of a future foreign
exchange loss if the $A depreciates since the borrower is required to repay the loan principal in 12 months time in
$US. Suppose that on the date of the raising of the loan, the Australian borrower enters into a foreign exchange swap
with a non-resident financial institution for the purpose of hedging the foreign exchange exposure. Under this
contract, the Australian borrower and a counter-party swap currencies at the current spot exchange rate, and agree
to swap them back on the maturity date of the original $US loan at the 12 month forward rate which, for simplicity, is
assumed to equal the current spot rate of 0.5240. This locks in repayment obligations with certainty, and the loan is
fixed in domestic currency terms by this derivative contract.

At the inception of this derivative contract, the Australian enterprise delivers the $US100 received from the loan to
the counter-party in exchange for $A190.84. This is recorded as a zero transaction in financial derivatives since the
net settlement value in $A terms is zero. The market value of this contract is also zero at the inception, since the
prevailing market rate and contract rate of the 12 month $A/$US swap contract are equal. In position statistics, as
exchange rates change over time, this contract will be in either a net asset position (in the money) or net liability
position (out of the money) based on the difference between the contract and prevailing market rate.

On 31 December 2000 the prevailing $A/$US spot rate is 0.5585. Assuming that the 1 November 2001 forward rate is
equal to this spot rate, the gross expected receivable under the swap contract is $A179.05 ($US100/0.5585), with a
gross payable of $A190.84. On this date, the swap is in a net liability position of $A11.79, which is equal to the
unrealised foreign exchange gain on the underlying loan. Taken together, the total liability of the Australian enterprise
is $A190.84, which is the same amount, in Australian dollar terms, as the original borrowing. Including the swap
contract in the position statement and valuing it at its market value more accurately reflects the economic position of
the enterprise, which in this case has eliminated its overall exposure to foreign exchange movements through the
use of the hedge.

Notional Value of a Derivative Contract

The ABS collects and publishes data on the current market value of all derivative contracts, including those entered
into for hedging purposes. However, these data, by themselves, do not show the extent to which enterprises have
hedged the net positions of their foreign-currency-denominated assets and liabilities. One way to obtain an
approximate measure is to collect information on the notional value of derivative contracts. To illustrate the
difference between the market value of a derivative contract and it notional value, the example of a hedge on a loan in
$US given above can be used. The example illustrates the derivation of the market price of the contract, namely
$A11.79. However, the derivative contract was entered into to cover the exchange rate exposure on a loan of
$US100, so its notional value is $US100. Such notional values are not needed for any national or international
economic accounting aggregates and, accordingly, are not normally collected by the ABS.To obtain a more complete picture, the ABS, with the assistance of the RBA, supplemented the Survey of
International Investment with additional information on foreign currency hedging from a wide range of enterprises,
both financial and non-financial. The aim of the supplement was to capture quantitative and qualitative data about
Australian enterprises’ foreign currency exposure and the risk management practices associated with that exposure.
An article containing the results of this survey is included in this issue of AEI on page 17.

SUMMARY OF TREATMENT IN NATIONAL AND INTERNATIONAL ACCOUNTS

The treatment of foreign exchange gains and losses in national and international accounts is consistent with the
principles outlined in SNA93 and BPM5. Foreign exchange gains and losses, in common with other capital gains or
losses, are not treated as income or expenditure in the economic accounts. They are wealth effects, not income
effects, and are therefore treated as valuation changes.Transactions in financial derivatives are treated as financial transactions in assets and liabilities and the foreign
exchange holding gains and losses associated with financial derivatives are reported as valuation changes.

Only derivative contracts between resident and non-resident counterparties are included in international accounts,
with transactions reported in the Balance of Payment’s financial account and foreign exchange gains and losses in
these contracts reported as valuation changes in International Investment Position statistics.

The treatment of foreign exchange gains and losses in ABS government finance statistics is consistent with the
treatment recommended in SNA93/ BPM5 and the IMF’s Government Finance Statistics Manual (2001 edition). Such
gains and losses are not treated as financial transactions but as “other economic flows” and have no impact on the
two analytical balances “GFS net operating balance” and “GFS net lending/borrowing” derived in the GFS Operating
Statement. However, they do have an impact on net worth - the analytical balance derived from the balance sheet.
Transactions in financial derivatives are treated as financial transactions in assets and liabilities, and foreign
exchange holding gains and losses associated with financial derivatives are treated as other economic flows. These
transactions and holding gains and losses have no impact on the two analytical balances derived in the GFS
Operating Statement. They do have an impact on net worth.

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